Question

As discussed in Chapter 14, leases that are in- substance purchases of assets should be capitalized— an asset and associated liability should be recorded for the fair value acquired. Mason Enterprises is considering acquiring a machine and has the option to lease or to buy by issuing debt. Mason also has debt covenants that restrict its debt- to- equity ratio to 2: 1. The purchase alternative would increase the debt- to- equity ratio precariously close to the restrictive limit and could result in the company’s going into default. Also, management bonuses are affected when the debt- to- equity ratio exceeds 1.5: 1. Mason’s management is aware that majority- owned subsidiaries must be consolidated. The president, Penny Mason, persuades the board to form a subsidiary that would own 49 percent of the stock. The rest of the stock would be sold to the public. Mason would retain control of the subsidiary by maintaining membership on the board of directors and selling the majority shares in small blocks to a number of investors.

Required: a. What is the economic substance of the lease transaction from the perspective of Mason Enterprises? Discuss. b. By forming the subsidiary, is Mason able to lease the equipment and keep the transaction off its balance sheet? c. According to the efficient market hypothesis, discussed in Chapter 3, would investors be fooled by the Mason financing strategy? Explain. d. According to agency theory, discussed in Chapter 3, management may act in its own best interest at the expense of owners. In light of this theory, what are the ethical implications of the Mason financing strategy? Discuss. e. Does the financing strategy provide financial statements that are representa-tionally faithful and unbiased? Discuss.